The Earnings Bomb Inside GE Capital

GE (GE) gave a presentation a few weeks ago designed to calm investors’ fears that the company’s huge financial services division, GE Capital, is just another Bear Stearns with a friendly logo.  The presentation helped, and GE’s stock has recovered some of its horrific losses.  As of this morning, it’s back above $11 (down from $40+ 18 months ago).

Some investors, however, are not convinced.  The inimitable Steve Eisman of FrontPoint Partners, for example, who was immortalized last year in Michael Lewis’s article about the end of Wall Street, detailed his thoughts about GE at Jim Grant’s annual conference a few days ago.

An investor in attendance was kind enough to forward Steve’s slides, and we’ve excerpted some of them below.  Here’s his bottom line:

GE Capital is currently hiding $40-$45 billion of embedded losses in the GE Capital portfolio.  This $40-$45 billion of losses, if rinsed through the income statement all at once, would wipe the company out.  In fact, if GE weren’t able to fund itself with the "heroin injection" of the government’s commercial paper program, it would already be bankrupt.

So is GE toast?

No. Unlike banks, GE is not required to mark its assets to market, so Eisman thinks the company will just hobble along for years as the bad news gradually works its way through its income statement (the very definition of a zombie bank).  The losses will hammer GE’s earnings, though.  Especially as the performance of the industrial business deteriorates.

We asked a GE analyst why the company seems unwilling to acknowledge this:

"Because they’re living on Planet GE," he said–"which is not even in this solar system."

Here are some of Steve Eisman’s slides:

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First, the bottom line: $41-$46 billion of embedded losses (bear in mind that these are all estimates.  GE would probably violently disagree):

And now the details…  Eisman says GE’s asset quality is low and that the company under-reserves relative to its competitors:

 

If GE were to increase its reserves to match the rest of the industry…

This would result in a huge hit to pre-tax earnings:

Next, the specific assets.  If GE’s financial investments were marked to market, the company would have to take an estimated $9 billion loss.

Marking GE Capital’s securities to market would result in an estimated $5 billion hit.

 

Next, GE’s residential European mortgage portfolio.  The Polish and Hungarian mortgages are paid in Swiss Francs.  Unfortunately, the folks who are supposed to pay them are paid in zlotis, etc–and the value of these currencies has plummeted against the Swiss Franc.  Steve Eisman re-calculates the loan-to-value ratios in the local currencies:

The UK mortgage portfolio is hurting, too.

Then there are GE’s Commercial Real Estate holdings. Eisman thinks this portfolio is worth up to 40% less than its carrying value.  Why?  Because most of the holdings (securities and buildings) were acquired at the peak of the market.  An investor familiar with GE’s real-estate investment timing described GE’s timing this way: "Why don’t you just put a fucking gun to your head and blow your brains out?")

 

Add all this up, Steve Eisman says, and you get $41-$46 billion of embedded losses on a $600 billion book of assets–enough to cripple GE’s earnings for years.